Chapter 17 Intercorporate Equity Investments

Impairment rules are generally going to generate soft numbers (low verifiability)
Special Purpose Entity (SPE)
A joint venture between a sponsoring company and a group of outside investors SPE is limited by its charter to certain permitted activities. Hence, the term “special purpose” comes from the limited scope of the SPE. Most common uses an SPE are
Pro Rata Consolidation ( 4th method)
Consolidation of assets and liabilities occurs only to the extent of the stock acquired by the parent An arbitrary distinction at the 50 % point where control is assumed does not exist
20% to 50%
>20%
Relevant Circumstances
The relevant circumstances that justify differential accounting for intercorporate equity investments depend on the level of influence held by the investor
Consolidation
A technique in which two or more entities are reported as if they are one common accounting entity Also called a businesstion Terms
Reporting on Intercorporate Equity Investments
1. Consolidated reporting as if the two separate legal entities are one accounting entity using either the purchase or pooling method (as appropriate) 2. Nonconsolidation using the equity method of accounting 3. Nonconsolidation using the fair (market) value approaches
Fair Value Method
Market value applies where no significant influence exists and market values are readily determinable for investments of approximately 20 percent or less Increases or decreases in market value may or may not go through income depending upon management’s intention to sell them in the near term
financing arrangements, leasing arrangements, and sales/transfers of illiquid or poor performing assets
Special Purpose Entity (SPE)
Hundreds of respected U.S. companies have an estimated $2 trillion of debt hidden in off-balance sheet subsidiaries such as SPEs. In a recent survey, 29 percent of the 141 CFOs responding indicated that some of their company’s debt was not reflected on the balance sheet. 3% reported that more than 50% of the corporate debt was off balance sheet. 42% of the companies that reported off balance sheet debt indicated that they guarantee or otherwise protect the investment of third parties in the SPEs, precisely the practice that led to Enron’s downfall and a practice that should lead to consolidation even though these companies report not consolidating the SPEs in question.
SFAS No. 94
Asserts, rather than demonstrates, that consolidated reporting (and the fictional accounting entity thus created) is more relevant to investors than are separate entity statements in which the reporting entity is the legal entity
SFAS No. 142
Goodwill is converted into an intangible asset
with an indefinite life but it is subject to write-off as an expense if it becomes “impaired.” Tests of impairment must be made on an annual basis.
Finite Uniformity for Intercorporate Investments
Ownership of Voting Stock >50%
Accounting Method
Consolidate per ARB 51 (SFAS No. 94) SFAS No. 141 and 142 Equity Accounting per APB Opinion No. 18 Fair (market) value for both trading securities and available-for-sale securities...
Combined enterprise Constituent companies Combinor Combinee
Consolidation
Central accounting issue is the valuation of the assets and liabilities of the separate entities being combined for reporting purposes FASB (1976) outlined three possible methods of accounting
Chapter 17: Intercorporate Equity Investments
Relevant circumstances Consolidation
Pooling of interests Purchase method New entity approach Pro rata
Equity method Fair value method Special Purpose Entity
New Entity Approach
Regard the combined enterprise as an entirely new entity Results in the use of current values for the assets and liabilities of all the separate entities as of the date the combination is consummated
Impairment test after acquisition compares
(1) the fair market value of the acquisition against (2) the historical cost of the net assets plus goodwill at an annual measurement date after acquisition. If (1) is greater than (2), no impairment has occurred. However, if (2) is greater than (1), goodwill is impaired and the impaired amount is written off as a loss appearing above income from continuing operations.
Three Levels of Control
Majority owned company: owner has effective control Majority owned company: control is only temporary or the majority owner does not have effective control Less-than-majority-owned companies: relevant circumstance is whether the investor can exercise significant influence over operating and financial policies